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Friday, March 30, 2012

I previously made the case that the Eurozone and Germany need to part ways. Now it appears Germany is effectively doing that by setting up a separate monetary zone inside the Eurozone. Here is Ambrose Evans-Pritchard (my bold):

The authorities in Berlin and Frankfurt are worried that the ECB’s 1pc interest rates are too low for conditions in Germany, where unemployment has fallen to its lowest in 20 years. The ECB’s €1 trillion (£834bn) blitz of three-year loans to banks has started to reignite monetary growth in Germany, even though the key aggregates are still collapsing in southern Europe...

The German authorities are in effect preparing a form of quasi-monetary tightening to offset ECB largesse.

Today I am at the Economics Blogger Forum in Kansas City. It is being hosted by the Kauffman foundation and many of my favorite bloggers are here. Some of the discussions will be live streamed today from here.

Fed Chairman Ben Bernanke delivered his fourth lecture yesterday. He used this lecture to showcase the Fed's response to the financial crisis. The Chairman covered a lot of ground in his talk but failed to discuss one of the most important ideas in understanding this crisis: the passive tightening of monetary policy. This occurs whenever the Fed passively allows total current dollar spending to fall, either through a endogenous fall in the money supply or through an unchecked decrease in velocity. This failure to act when aggregate demand is falling has the same impact on the stance on monetary policy as does an overt tightening of monetary policy. And the damage done by a passive tightening is no different than that of an overt tightening. The only difference is that the public is more aware of the overt form.

Bernanke agrees. Back in late 2010, he acknowledged the possibility of passive tightening and used it as a justification for stabilizing the size of the Fed's balance sheet (my bold):

Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome. In response to these concerns, the FOMC agreed to stabilize the quantity of securities held by the Federal Reserve by re-investing payments...By agreeing to keep constant the size of the Federal Reserve's securities portfolio, the Committee avoided an undesirable passive tightening of policy that might otherwise have occurred...

In short, the FOMC was concerned that a failure by the Fed to reinvest its mortgage receipts, which would amount to a reduction in the monetary base, would be contractionary. But even that may not be enough. The Fed could stabilize the size of its balance sheet and still be passively tightening if a sudden rise in money demand occurred was not accommodated by the Fed. In fact, the Fed could even be expanding its balance sheet and still be passively tightening if the demand for money was growing faster than growth of Fed liabilities.

Now all of this is important because a key reason for the financial crisis is that the Fed passively tightened monetary policy starting around mid-2008. This can be seen in the figure below:

The figure shows that despite the fall in the growth rate of personal income from construction and real estate services that began in early 2006, personal income in the rest of the economy continued to grow at about 5% a year up through mid-2008. The Fed was able to stabilize nominal incomes overall for almost two years while structural changes were taken place in those sectors closely tied to the housing boom. This is a remarkable accomplishment and is especially clear when comparing construction employment with all other employment:

But around mid-2008 the Fed began failing to sufficiently respond to the decline in expected aggregate demand growth. Thus, it began passively tightening around that time as can be seen in the two figures below. The first figure shows the spread between the nominal and real yield on 5-year treasuries. It fell about 170 basis points during the period leading up to the collapse of Lehman in September. This decline in inflation expectations implies a decline in expected aggregate spending and thus a passive tightening of monetary policy. (Even if the spread was reflecting a heightened liquidity premium during this time the implication is the same. A heightened liquidity premium indicates increased demand for liquidity that, in turn, also implies less spending.)

The decline in expected aggregated demand began affecting current spending decisions as seen below. Nominal GDP began falling in June 2008.

The Fed's failure to stabilize and restore aggregate demand meant it was passively tightening. This failure to act was epitomized by the Fed's decision in September, 2008 to not lower the federal funds rate despite the collapsing economy. This passive tightening is what turned a mild recession into the Great Recession. Note that the financial crisis was a consequence of this failure, not the cause. Just like in the Great Depression, the Fed's failure to stabilize aggregate demand lead to a severe financial panic. But you will never hear Chairman Bernanke admit it. For it would not be good PR for the Fed to acknowledge its failure. And that is why Bernanke did not discuss the passive tightening of monetary policy in his lecture.

Thursday, March 29, 2012

A number of commentators on the last post seemed surprised by my claim that U.S. monetary policy exacerbated the shortage of safe asset problem during the early-to-mid 2000s. The argument that the Fed can influence the global demand for safe assets should not be controversial. The Fed, after all, has an inordinate impact on global monetary conditions and can influence long-term yields by managing expectations. Obviously, the Fed is not the only determinant of global safe asset demand as I have acknowledged manytimes by noting there was a structural component as well. And yes, financial innovations, poor governance, misaligned creditor incentives, and other private sector failings played a role too. But to claim the Fed had no influence on the demand for safe assets during the housing boom requires ignoring what seems to me to be the obvious. It also requires ignoring what folks on Wall Street have to say. It also ignores rigorous empirical studies by folks at the Bank of England, the ECB, and the OECD. It is a shame that these studies are ignored by Bernanke and other apologists of Fed policy during the housing boom.

Tuesday, March 27, 2012

Somewhere in the halls of George Washington University, after Bernanke's last lecture, a conversation between the Fed Chairman and a student was overhead. This is the first part of that conversation.1

Student: Oh hi, Chairman Bernanke. I have enjoyed your lectures. Thanks so much for making time for us.

Bernanke: You are more than welcome. You know, it has been a real treat for me to get away from the Fed and back into the classroom. Sometimes the stress of dealing with hard-money congressmen, rogue regional Fed presidents, and bloggers who cite my Japanese work can be overwhelming. So it really is nice to escape into the classroom. Now tell me, is there anything in particular we have talked about that struck your fancy?

Student: Actually, yes. When you explained that China's currency peg to the dollar means China effectively has it monetary policy set by the Fed I was shocked--1.3 billion Chinese have their monetary conditions set by a few Americans holed up in a secretive, old building on the other side of the world. Wow, talk about fodder for conspiracy theories! Anyhow, this got me thinking: are there other countries that have their monetary policy determined by the Fed too? So I did some research and learned that almost half of the world's currencies are tied in some way to the dollar. This translates into about a third of world GDP. That means you guys at the Fed are like a monetary mafia, right?

Bernanke: Well, uhm, I would not phrase it that way but...

Student: But you do influence monetary conditions for about a third of the global economy, right?

Bernanke: Yes.

Student: Okay, let's say the Fed eased monetary policy for a third of the world economy. That would imply that the currencies of these dollar-pegging countries would depreciate relative to the rest of the world. And that, in turn, would make the ECB and the Bank of Japan mindful of U.S. monetary policy lest their currencies becomes too expensive, right?

Bernanke: Probably, but...

Student: So the Fed, then, is also shaping monetary policy to some extent at the ECB and the Bank of Japan. That explains figures like this one and this one that until now I did not understand. Wow, you guys really are the monetary mafia. So does this mean the monetary mafia thinks about the implication of the FOMC's actions for these other economies when doing monetary policy?

Bernanke: Actually no, we have a domestic mandate so we don't really worry too much about them unless they create problems for the U.S. economy. And besides, they don't have to peg to our currency. No one is forcing them to do so. We may exert a lot of influence on global monetary conditions, but we are not a monetary mafia! Please quit using that name!

Student: Okay, no more monetary mafia references. But, if you do exert a lot of influence on global monetary conditions, then can't it explain, at least in part, why there was a global housing boom? The Fed lowered global interest rates and sparked off a global housing boom, right?

Bernanke: You need to read my papers on the saving glut. They show that it wasn't U.S. monetary policy, but excess savings from rest of the world that created the demand for safe assets that in turn drove down global interest rates. This development combined with the securitization of finance, poor internal governance, misaligned creditor incentives, and other private sector failings is what caused the global housing boom.

Student: Doesn't that sound a bit self-serving, blaming only foreigners and private sector failings for the housing boom?

Bernanke: Look, as I said, read my papers on the saving glut. The answers are all there.

Student: Well, I have read your saving glut papers, but I still have questions. It seems to me that in those papers you are focusing on the structural component driving the global demand for safe assets, but ignore the cyclical ones.

Bernanke: What do you mean?

Student: The structural component is that global economic growth over the past few decades has outpaced the capacity of the world economy to produce truly safe assets. The cyclical component, on the other hand, is that because of the Fed's monetary superpower status, U.S. monetary policy accentuated the demand for safe assets during the housing boom.

Bernanke: Oh really?

Student: Really. Here is why. First, in the early-to-mid 2000s, those dollar-pegging countries were forced to buy more dollars when the Fed loosened monetary policy with its low interest rate policies. These economies then used the dollars to buy up U.S. debt. This increased the demand for safe assets. To the extent the ECB and the Bank of Japan also responded to U.S. monetary policy, they too were acquiring foreign reserves and channeling credit back to the U.S. economy. Thus, the easier U.S. monetary policy became the greater the demand for safe assets and the greater the amount of recycled credit coming back to the U.S. economy.

Second, when the Fed pushed interest rates low, held them there, and promised to keep them there for a "considerable period" in 2003 it created new incentives for the financial system. First, via the expectations hypothesis (which says long-term interest rates are simply an average of short-term interest rates over the same period plus a term premium) these developments pushed down medium to longer yields as well, as seen in this figure. This drop in yields caused big problems for fixed income fund managers who were expected to deliver a certain return. Consequently, there was a "search for yield" or as Barry Ritholtz says the managers of pension funds, large trusts, and foundations had to "scramble for yield." They needed a higher but relatively safe yield in order to meet their expected return. The U.S. financial system meet this rise in demand by transforming risky assets into safe, AAA-rated assets. The Fed's low interest rate policies also increased the demand for safe assets for hedge fund managers. For them the promise of low short-term interest rates for a "considerable period" screamed opportunity. These investors saw a predictable spread between low funding costs created by the Fed and the return on higher yielding but safe assets. They too wanted more AAA-rated assets to invest in so that they could take advantage of this spread that would be around for a "considerable period." Here too, the U.S. financial system responded by transforming risky assets into safe assets. So what do you think Mr. Chairman?

Bernanke: Well, what do you know, I am out of time. We will have to continue this conversation next time after my next lecture on the financial crisis.

Student: Speaking of the financial crisis, I also think that since late 2008 the Fed has erred the other way. By failing to first prevent and then restore aggregate nominal income to its expected path, the Fed allowed the large scale destruction of many privately-produced safe assets far beyond that needed to correct for the housing boom.....

Tuesday, March 20, 2012

Is it time to start panicking about the recent rise in long-term treasury yields? Are the bond vigilantes finally attacking? Ryan Avent says no. I agree and am quite elated to see long-term yields rising. You should be happy too. Here is the reason why:

This figure shows that the expected growth rate of nominal GDP or aggregate demand is strongly related to the 10-year treasury yield. Thus, the recent rise in long-term yields can be interpreted as the bond market pricing in a rise in the expected growth of aggregate demand. And that is great news given the ongoing aggregate demand shortfall in the U.S. economy.

In the past few weeks, the risk of recession in the developed economies has fallen sharply, both because of the actions of the ECB, and because of the recovery in the labour market in the US. It is true that global GDP growth has remained very subdued in 2012 Q1, at around 2 per cent in the US and zero in the eurozone, with much worse to come in the eurozone in Q2. It is also true that GDP growth in China appears to be dropping into a 7-8 per cent range, which is well below normal. But the market is now disposed to view these sluggish GDP figures as temporary, and not the harbinger of future recession.

This has led to what might be termed a “healthy” sell off in government bond markets, in which rising growth expectations have reduced the probability which the market attaches to further QE from the central banks. Equity prices have risen to reflect this. Credit spreads have narrowed for the same reason. The rise in government yields, while belated, is a natural counter-part to these shifts in other markets.

Another way of saying this is that the long-term natural rate of interest, the long-term interest rate consistent with underlying economic fundamentals, is starting to rise. This is an important point because it undermines the claim made by folks like Bill Gross that the Fed is harming savers and investors keeping interest rates low. While it is true that the Fed's large scale asset purchases (LSAPs) over the past few years probably have lowered the risk premium on long-term yields, this effect has been shown to be small compared to the 300 basis points plus drop in the 10-year treasury interest rate since 2007. What really was driving down long-term yields was a weakened global economy. Now that there are signs that it is improving, savers and investors should begin to earn higher real returns. So much for the financial repression view.

Had it been better understood by the public that causality runs from improved economic outlook to higher interest rates, and not the other way around, then maybe there would have been more willingness by Fed officials to do to fully restore aggregate demand. I hope this lesson gets learned and it is not repeated.

Update: Lars Christensen reaches the same conclusion using the equation of exchange.

Friday, March 9, 2012

Betsey Stephenson and Justin Wolfers take us on a journey to Hundred Acre Wood:

Eeyore and Tigger have become central bankers. The wood's economy is suffering the repercussions of a recent honey binge. Both Eeyore and Tigger want to help the recovery along, a goal they hope to achieve by holding interest rates low for a long time. But each communicates this differently.

Chairman Eeyore is a true dismal scientist, who sees bad news everywhere. He's sure the economy will be in the doldrums for years. Indeed, he's so worried that folks who don't understand his pessimistic outlook will make bad decisions that he gives a speech warning them about it. He says the economy is so weak that he'll need to keep rates low for several years. Eeyore's message is so sobering that it mutes the desired stimulus effect of the low interest rates. After all, why would you buy anything, or invest in producing it, if you have just learned that some of the smartest forecasters in the country think the economic outlook is so awful that they dare not raise rates until 2014?

Chairman Tigger has a totally different approach. He figures that the prospect of a terrific party will revive everyone's animal spirits. He also knows what folks are thinking: Every time the economy gets going, the Fed spoils the party by taking away the punch bowl -- that is, by raising interest rates to keep inflation in check. So Tigger gives a speech promising to keep interest rates low for several years -- even when the economy recovers.The prospect of low interest rates sustaining a long and robust recovery leads everyone to start spending. After all, good times are just around the corner.

Eeyore and Tigger both did essentially the same thing. They announced that interest rates would be low for several years. But their messages are importantly different, and so yield very different effects.

Their point is that Ben Bernanke has been acting too much like Chairman Eeyore. I agree, but would add that it is nearly impossible for Bernanke to act differently given the format of the new long-term interest rate forecasts. The format shows where FOMC officials expect the federal funds rate to be over the next few years. What is missing and essential for knowing the stance of monetary policy is the expected natural (or equilibrium) federal funds rate. A federal funds rate is only stimulative if it is below its natural rate level. It is not enough for the federal funds rate to be low, for the natural interest rate could be low too.

If the FOMC would show the forecasts of the actual and the natural federal funds rates over the various forecast horizons, then the public could know with much more clarity the Fed's intentions. Until then, the Fed's new communication strategy is at at best white noise to the market and at worst worst a quagmire of confusion.

Greg Ip has a new article in The Economist where he discusses how U.S. treasuries and other safe assets can serve as medium of exchange:

[D]emand for American government debt is driven by much more than a hunger for returns. Financial-market participants use Treasury bonds and bills as collateral to secure lending, for instance. And for risk-averse investors such as foreign central banks, money-market funds and retirees, America’s debt is uniquely suited to storing savings without much due diligence. In short, its government debt is a lot like money.

I agree with the central premise of the article, but would add a few points.

First, I would frame the discussion in this way: there are retail money assets and institutional money assets. Retail money assets are the traditional money assets measured by the M2 money supply and are used by households and small businesses. Institutional money assets go beyond M2 and includes treasuries, commercial paper, repos, GSEs, and other safe assets used to facilitate exchange in the shadow banking system. Since most of the creditors to the shadow banking system are institutional investors, these assets should be called institutional money assets.

Second, institutional money assets include both privately-produced and publicly-produced safe assets. If the Fed is doing its job and and providing sufficient aggregate demand to keep the economy at full employment, then there should be plenty of privately-produced safe assets. Only if the Fed allows nominal spending to crash, which would reduce privately-produced safe assets, is there a need for the government to step in and create safe assets. To put it differently, if the Fed were to announce today that it was adopting a nominal GDP level target and planned to restore it to its pre-crisis trend, then there would most likely be a recovery and an increase in the private supply of safe assets. As a result, the institutional money asset supply would increase and there would be less need to produce treasuries.

Third, the broader context for this discussion is that there is currently a shortage of safe assets for the global economy. And, as I noted before, there is both a long-term, structural dimension to this problem as well as a short-term, cyclical one:

The structural dimension is that global economic growth over the past few decades has outpaced the capacity of the world economy to produce truly safe assets, a point first noted by Ricardo Cabellero. The cyclical dimension is that the shortage of safe assets was intensified by the Great Recession, a point stressed by Gary Gorton. I previously made the case that both the Fed and the ECB were an important part of the cyclical story by failing to restore nominal incomes to their expected, pre-crisis paths. In other words, since 2008 the Fed and the ECB passively tightened monetary policy which caused some of the safe assets to disappear while at the same time increasing the demand for them.

This failure of the world's major central banks means U.S. treasuries will remain in hot demand. This seemingly insatiable demand is evidenced by the low yields on treasuries.

Fourth, there is a Triffin dilemma for U.S. debt. The global financial system in its current setup needs increasing amounts of U.S. treasuries. This means the U.S. government must continue to run large budget deficits. Over time, however, these large budget deficits may jeopardize the safe-asset status of U.S. treasuries, the very thing driving the insatiable demand for them. So a tension exists between providing enough treasuries to keep the global economy going and maintaining the safe-asset status of treasuries.

Finally, the New Monetarists like David Andolfatto have been making some of these points for awhile. Greg Ip should spend some time talking to them as well.

Wednesday, March 7, 2012

Over the past few years, many writers have made the claim that Milton Friedman would roll over in his grave if he knew what Ben Bernanke was doing at the Fed. These observers claim that both the ad-hoc nature and scale of monetary policy intervention would never be sanctioned by Milton Friedman. I and others have responded many times that except for the former point, this critique is wrong. Just look at Milton Friedman's own words to see why. Nevertheless, this "What would Milton Friedman Say?" critique against Bernanke's Fed keeps reappearing in prominent media outlets like a never-ending whack-a-mole game.